2013-11-22 09:05:26
How economic uncertainty dulls investment
IT TAKES a cool head to invest. A firm s decision to build up capacity or spend
cash on research pays out tomorrow but must be paid for today. That makes
investment returns uncertain, influenced by factors from oil prices to politics
that firms cannot control. With rich-world investment rates looking anaemic,
many wonder why big firms are hoarding cash rather than putting the money to
work. According to new research, doubts about the future, some of them
self-inflicted, are a likely cause.
Common sense suggests that doubt might dull investment. But in some cases
uncertainty might spur investment too, as an influential 1996 paper* by Avner
Bar-Ilan of the University of Haifa and William Strange of the University of
British Columbia argued. The authors first observation was that investment
building a house to sell, say takes years. The protracted time to build means
that if property prices shoot up, only the builders who started work years ago
benefit. In addition, since long-term projects can often be shelved or sold
while under way, downside risks are limited. In other words, the potential
benefits of investment in such circumstances exceed the potential costs, making
investment a rational choice despite the unknowns.
Testing such theories requires an empirical calculation of the relationship
between investment and uncertainty. Yet measuring uncertainty is tricky, as is
untangling it from the decision to invest. Some investments splashing out on a
pricey advertising campaign, or buying a rival firm create uncertainty of their
own. In other cases a big investment can reduce worries about where a firm is
headed. Because the relationship is two-way, with investment and uncertainty
influencing one another, simple correlations of the two variables can jumble
the effects.
In a 2007 paper Nick Bloom of Stanford University, Stephen Bond of Oxford and
John Van Reenen of the London School of Economics showed one means of avoiding
this reverse causality . They took data for a sample of 672 British
manufacturing firms between 1972 and 1991, and turned to stock-price volatility
as their measure of uncertainty. When looking at investment in a given year,
they use previous years uncertainty in their analysis. The logic is that past
uncertainty tends to predict current uncertainty pretty well: there is more
doubt about some firms than others. But historic volatility cannot be
influenced by a firm s current investment decisions, making it a clean measure.
The analysis reveals that as uncertainty rises, firms cut investment rates and
respond less to investment opportunities.
A paper published this year relies on more timely data. Luke Stein of Arizona
State University and Elizabeth Stone of Analysis Group, a consultancy, study
3,965 American firms between 1996 and 2011. They first collect data on options:
contracts that give the right to buy and sell stocks in the future. Since
options prices represent traders estimates of future stock values, a wider
spread between the price of a share when the option is sold and the one at
which it can be exercised indicates greater uncertainty about where a firm is
heading. The data allow the researchers to work out the future implied
volatility for each firm.
That still leaves a causality conundrum: implied volatility will tend to be
influenced by firms investment decisions. To get a clean volatility measure
the researchers looked at forms of uncertainty that companies cannot control
changes in oil prices and exchange rates. These hit different firms in
different ways: an oil-price spike, for example, is good for oil producers, bad
for airlines, and only slightly negative for retailers. As a first step, they
work out how much of each firm s implied volatility has its root in some
economy-wide uncertainty. The rest they ignore, since it could be down to
bosses investment decisions.
They find that doubts about tomorrow have a big influence on what happens
today. For every ten percentage points their measure of uncertainty rose,
investment fell by one percentage point. During the financial crisis of
2008-09, for example, they calculate that implied volatility rose by almost 40
percentage points, suggesting a drop in investment due to uncertainty of just
under four percentage points. That implies that uncertainty accounted for
around half of the total drop in investment during the crisis. And it is not
just spending on physical assets that declines. The authors find that other
long-term outlays hiring staff and launching advertising campaigns also plunge
when uncertainty rises.
Lifting the fog
Those in charge of fiscal and monetary policy should heed the research. Some
types of uncertainty oil shocks, wars are beyond their direct influence. But
the research of Messrs Bloom, Bond and Van Reenen shows that when uncertainty
is high, companies response to policy stimulus tends to be muted. With worried
firms sitting on their hands, crisis-response medicine needs to be generous,
with a shot of stimulus to offset the slump, and an extra one to assuage
corporate bosses anxieties. It is a lesson central banks seem to have learned:
every one of them among the G7 club of big economies has committed itself to a
long period of low interest rates.
Governments, however, are still breeding fears about the future. The most
glaring form of uncertainty in the rich world is fiscal. In the euro area
cash-strapped peripheral states rely on bail-outs from richer members or the
IMF. As each round of talks on a banking union, or a deposit-insurance scheme
approaches, sensible bosses decide to wait and see what happens. In America
endless budgetary brinkmanship has led to a quarterly debate over whether the
government will default on its debts (the next deadline is in February). This
is self-imposed uncertainty. If the fiscal path were a little clearer, the
reduction in uncertainty should spur investment and output, which in turn
should improve the fiscal picture. To cut the debt, first clear the doubt.
Sources
Investment lags , Avner Bar-Ilan and William Strange, The American Economic
Review (Jun 1996)
Uncertainty and investment dynamics , N. Bloom, S.R. Bond and J. Van Reenen,
Review of Economic Studies (2007)
The Effect of Uncertainty on Investment, Hiring, and R&D: Causal Evidence from
Equity Options , Luke Stein, Elizabeth Stone (2012)